Milking the Tax System: Why VAT Exemptions Sour the Market

By Tormalli Francis, Research Analyst at Advocata Institute

A VAT-free litre of milk or cup of yoghurt may feel like relief at the checkout, which is in fact a silent distortion of lost revenue, stifled competition, and a marketplace where not all producers compete on an equal playing field. The government’s VAT exemption on locally produced milk and yoghurt is presented as a move to improve child nutrition and support local dairy farmers. On the surface, it appears humane and sensible — after all, what government wouldn’t want to make nutritious food more affordable while reducing dependence on imports?

But public policy, like milk, can curdle if left unchecked.

Milk production in Sri Lanka is a long-standing traditional industry that has endured for thousands of years producing over 500 million litres of milk [1] annually (Figure 1) with more than 130,000 farmers [2] (Figure 2) contributing to the production of milk islandwide. Yet this exemption, packaged with its good intentions highlights a recurring policymaking problem in the Sri Lankan economy: sacrificing long-term efficiency for short-term optics. In reality, VAT exemptions — however well-intentioned often distort the tax system, weaken the fiscal base, and may ultimately harm both consumers and the very farmers they are meant to protect.

Figure 1: Trend of total annual local milk production (Million Litres), 2015 - 2024

Source: Livestock Statistics, Department of Census and Statistics.

Figure 2: Number of dairy farmers by district, 2024

Source: Livestock Statistics, Department of Census and Statistics.

Equal Tax, Equal Opportunity

In a sound tax system, neutrality is essential — similar goods should be taxed in similar ways, and the system should not favor one product or producer over another. Exempting only locally sourced milk and yoghurt breaks this principle. It grants preferential treatment to domestic producers, while imported milk powder which is still a staple in many urban Sri Lankan households remains subjected to VAT. This selective exemption can hinder fair competition, discourage innovation, misallocate resources, ultimately compromising market efficiency.

This distorts market dynamics. Producers of other dairy products such as cheese, butter especially curd face a cost disadvantage, not because of inefficiency, but because of policy. The exemption becomes a de facto subsidy, not through open direct government expenditure but through hidden distortion in the tax system.

A country case example of a similar situation is seen in Georgia [3], where VAT exemptions apply to domestically produced milk and dairy products, but not to imported or reconstituted alternatives.  While intended to support local farmers and consumers, this approach creates an uneven competitive environment. Producers who rely on imported inputs including those making value-added dairy products face rising costs without benefiting from the exemption. 

Such policies also break the VAT chain, as inputs are subjected to VAT and outputs are exempted. This raises production costs, especially for downstream manufacturers, distorts price signals, and leads to inefficient resource allocation across the sector. 

Undermining Revenue for Reform

In the context of Sri Lanka's fiscal challenges and commitments to international financial institutions like the IMF, the Advocata institute emphasizes the importance of broadening the tax base. VAT exemptions reduce potential government revenue, which could otherwise be allocated to essential public services or targeted welfare programs. Maintaining a wide array of exemptions complicates tax administration and undermines efforts to achieve long-term fiscal sustainability.

When tax revenue is eroded by such sector-specific exemptions, this shifts the burden elsewhere — either to other goods or services or to government borrowing. Sri Lanka is in a period of fiscal crisis, with IMF-backed reforms requiring revenue generation. Exemptions reduce tax income from a high-volume essential product, limiting funds for healthcare, education, or infrastructure. Ad hoc policy changes and weak tax administration have been the major contributors towards the decline in tax revenue which have brought in fiscal challenges. A well developed tax system is an efficient revenue instrument, but exemptions and reduced rates erodes its performance. Basic commodities as milk and yoghurt are often the options for exemptions or reductions in most Low Income Developing Countries (LDICs), in 2020 the VAT exemptions in these countries amounted to 1.3 percent of GDP [4]. Revenue loss from such policies tends to outweigh the actual gains for the vulnerable groups.

Better Tools for Better Targets

A key justification for exemption on milk and yoghurt is to improve nutrition and support dairy farmers — by making these products more affordable for vulnerable groups and increasing farmer incomes. The dairy industry has been identified as the priority sector for development among the other livestock sub sectors in the country [5] for its crucial role reducing nutritional deficiencies across all age groups, and serving as a key source of affordable, high-quality nutrition for the population. 

But VAT exemptions are an imprecise way to deliver support. While they aim to make basic commodities more affordable, the Advocata institute highlights that such blanket policies often result in an imbalance as higher-income households benefit more than the intended low-income groups. As a greater proportion of basic commodities are consumed by the richer households, with greater purchasing power as they are likely to capitalise on these tax breaks. This misalignment highlights the inefficiency of VAT exemptions as a tool for social welfare. It is, in essence, a regressive subsidy disguised in the language of progressivism.

With exemptions having a progressive impact, they are poorly targeted ways to help low-income households, showcasing that directly targeted mechanisms will be better tools to address distributional concerns [6]. If the goal is to improve nutrition among the most vulnerable and farmers' livelihoods – Sri Lanka should focus on strengthening targeted, transparent support systems. Direct transfers to low-income households, investment in school milk programs, input subsidies to farmers, and upgrading the dairy industry infrastructure would deliver an efficient and equitable alternative. These measures ensure that support reaches those who need it most—without distorting market signals or undermining long-term efficiency.

Conclusion

Sri Lanka’s VAT exemption on locally produced milk and yoghurt may feel like a compassionate move — and in some ways, it is. But ultimately, it’s a fiscal quick fix, not a structural solution. A neutral tax system with broad based rates and minimal carve outs helps maintain fairness, supports productive specialisation and sustains government revenue. 

If we want to nourish our economy as well as our children, we must move from tax distortion to targeted policy. Milk can be good for the bones, but only when it doesn’t weaken the backbone of the economy.

[1]  Milk Production Statistics. Livestock Statistics. Department of Census and Statistics. Available at: https://www.statistics.gov.lk/Agriculture/StaticalInformation/MilkProduction#gsc.tab=0

[2] Milk Producing Farmers. Livestock Statistics. Department of Census and Statistics. Available at:https://www.statistics.gov.lk/Agriculture/StaticalInformation/MilkProducingFarmers#gsc.tab=0

[3]  Study of Value Added Tax (VAT) Exemption Impact for Increasing the Competitiveness of the Georgian Dairy Sector. Available at: chrome-extension://efaidnbmnnnibpcajpcglclefindmkaj/https://iset-pi.ge/storage/media/other/2021-10-06/32dcec80-2670-11ec-9a47-851d3f3d5dcf.pdf

[4] The Global Tax Expenditures Database (GTED) Companion Paper. A. Redonda et. al. Available at: https://www.researchgate.net/profile/Christian-Von-Haldenwang/publication/352539392_The_Global_Tax_Expenditures_Database_GTED_Companion_Paper/links/61291b602b40ec7d8bca280d/The-Global-Tax-Expenditures-Database-GTED-Companion-Paper.pdf

[5] Sri Lanka’s Dairy Sector: Where to Move and What to Do – Prediction and a Trend Analysis. D. A. P. R. Damunupola. Available at: chrome-extension://efaidnbmnnnibpcajpcglclefindmkaj/https://sljae.sljol.info/articles/74/files/submission/proof/74-1-413-1-10-20220706.pdf

[6] VAT Exemptions, Embedded Tax,  and Unintended Consequences. World Bank Group. Available at: chrome-extension://efaidnbmnnnibpcajpcglclefindmkaj/https://www.joserobertoafonso.com.br/wp-content/uploads/2025/05/IDU-8b2c8bb9-1d8f-4d67-b704-8dec2f14a832.pdf

Price Regulation on Three-Wheelers and School Vans: A Recipe for Transport Troubles

By Gurubaran Ravi & Chanul Singharachchige

Price is fundamental in determining the manner in which market forces influence both patterns of demand and the chains of supply. Price is a manifestation of what economist Adam Smith termed the ‘invisible hand’ which naturally allocates scarce resources in accordance with the laws of supply and demand and requires near zero intervention. The question now lies: what happens when this unneeded intervention is implemented regardless? By manufacturing limitations around prices, the government disrupts the natural balance between supply and demand. With the government planning to introduce a series of price controls on the three wheelers , school and office transportation sector - upon which almost all of us rely - it is worth revisiting what the adverse consequences of such an act can and will look like, how they will most definitely exacerbate already existing problems, and finally, prevent the economy from finding its own equilibrium.

Essentially, price controls entail putting restrictions as to how high or low prices can be set for a certain good or service via ‘price ceilings’ and ‘price floors’ respectively. Conceptually speaking, the implementation of price controls is often for a given purpose, whether it be to control inflation or protect consumers, the government simply tries to artificially balance distortions within the market creating a great deal of uncertainty in the economy itself.

However, not all that is expected to come into fruition in theory can be seen in the outcomes found in objective reality. For example, despite the immediate benefits price controls may provide, they distort the natural dynamics of the market leading to unintended consequences such as supply shortages, the reduction in the quality of goods and services, and the prevalence of underground black markets. This tends to be because producers struggle to cover the costs associated with providing products at pre-established prices. The ultimate harm done to both consumers and producers through the implementation of such regulation - though often well-intentioned - outweighs any temporary benefits that may be reaped. 

Now, let us take a closer look at what the landscape of how the transport market for three wheelers in Sri Lanka looks like and behaves. Nowadays, three-wheelers, school vans, and office vans have become integral parts of the Sri Lankan transportation system - especially with the deterioration of the public transportation system. The three-wheeler segment comprises a significant portion of Sri Lanka’s transport sector with more than 300,000 three-wheelers in operation. These vehicles have made it possible for millions of people to have their means of private transport for daily use, particularly in rural areas and other hard-to-reach places. In the backdrop of an economic crisis, where operating costs become extremely high, the proposed price regulation policy is likely to jeopardize this important service. Such regulation could reduce the number of providers as the financial pressure on operators rises, the availability of transport decreases, and transport fares rise. This impact would be most severely experienced in regions where choices of public transport are already few, possibly leaving many with no affordable means of transport. 

The transport sector for three-wheelers is also mainly composed of individual operators, but recently a few companies like PickMe and Uber have utterly revolutionized Sri Lanka's transport market. They have managed to heighten efficiency, promote route optimization, and enhance service quality, whilst simultaneously providing alternate employment opportunities for a vast and diverse array of people. However, any proposed regulations that stifle the freedom with which price can move will inevitably disrupt the market dynamics fostered by these platforms. Experts warn that such constraints will undermine the flexibility and efficiency of the sector, distort supply and demand, and potentially reverse the benefits of market-based pricing models. This could lead to diminished levels of availability of service, hindrances in the pace of innovation within the industry, and a rollback of the advancements made in respect to meeting needs of consumers - particularly those of low-income earners. 

The free market fosters levels of competition that incentivize providers to one-up one another at every opportunity. In the service-based industries - such as transport - this is best accomplished through the provision of high quality services at as low a price as possible in order to attract consumers. Therefore, if price controls are implemented on the three-wheeler, school,  and office transportation sectors, they stifle the capacity as well as the incentives that providers have to improve levels of flexibility and provide a variety of options to consumers, particularly affecting low-income individuals. These price controls also significantly enlarge an industries’ reaction time - and hence inefficiency- when making adjustments in respect to pricing and supply when faced with fluctuations in economic conditions such as shifts in the levels of inflation or a fuel crisis. Experts in the field have shared similar concerns, emphasizing the fact that while these regulations may be passed in order to provide temporary relief to a select few, they risk the destabilization of the entire market and jeopardize the efficiency of the entire market system.

However, it is impossible to turn a blind eye to the fact that there are certain factors that are crucial to these price controls. The government has to consider how it will be able to oversee and regulate thousands of independent operators across the country, especially in a sector that is as fragmented as the transport sector. The adoption of such regulations would likely require a high administrative cost, which would likely shift attention from other important sectors. Moreover, given the fact that the three-wheeler, school, and office transportation sectors are composed of many small participants, it remains doubtful whether such enforcement can be achieved in the first place. For instance, it may be hard to enforce compliance in rural regions and in urban regions with dissimilar levels of economic development. This may lead to a situation where only some or even a part of the controls are being implemented, thus aggravating and distorting the market more than it is at the moment. The efficiency of these measures is furthermore rather questionable, which leads to questions of whether or not these measures can be implemented without causing more problems than they are solving.

However, the three-wheeler, school, and office transportation sectors are far from the only sectors that have known the weight associated with the adverse consequences of price control implementation. It should be highlighted that LP gas, cement, bread, rice and eggs, have all been subject to similar limitations. These policies have frequently caused significant market distortions. In 2023, in order to combat a sharp rise in the prices of eggs, the Sri Lankan government made the decision to impose price controls on eggs. Despite this intervention aiming to resolve the dilemma, it instead devastated the industry and led to severe shortages in the supply chain with producers failing to sustain costs. The restrictions on LP gas and bread supplies appear to have influenced supply chain disruptions and market fluctuations. Moreover, there is news that cement may be the next to be affected by further price regulations, which will exacerbate the situation in the building and construction industry. Such stopgap regulations impair the normal functioning of free market economics, send misleading signals to actual price factors, and cause more instability in the economy, by providing only short-term relief while exacerbating long-term structural issues.

While the debate around price controls is critical, it raises a more significant question: The public transport system needs to be improved based on the government’s long-term vision of how it plans on fixing the system’s problems. While exercising the price control mechanism may give some relief to commuters and public transporters in the short run, it cannot address the structural issues that are inherent in the public transport system in Sri Lanka. The real solution is to create an integrated plan to upgrade public transport infrastructure and to improve service delivery so that the public transport system becomes the first choice of the transport user. In this regard, it would be possible for the government to ease the burden from the private transport sector, including three-wheelers and school vans, etc., and thereby develop a more balanced transport system. The provision of mass transit systems offers not only the purpose of decreasing reliance on private automobiles but also social justice, optimum resource utilization, and preservation of the earth.

On a more conclusive note, history teaches us a clear lesson: the fundamental importance of allowing prices to reflect supply and demand naturally simply cannot be understated and any intervention in this intricate relationship can have dire direct and indirect consequences.While interventions like price controls may provide temporary relief to a select few, they often just exacerbate already convoluted issues when considering the longer term.  A free market system is pivotal in order to maintain economic equilibrium where efficient resource allocation can be best fostered. In such a system, it is price that serves as the principle signal to guide both consumer and producer behavior. The self-regulating nature of this system not only promotes innovation and competition but helps mitigate market distortions that may arise from intervention or excess regulation.